Investment Timing Option: Option Analysis
Kim Hotels is interested in developing a new hotel in Seoul. Thecompany estimates that the hotel would require an initialinvestment of $20 million. Kim expects the hotel will producepositive cash flows of $3 million a year at the end of each of thenext 20 years. The project's cost of capital is 13%.
Kim expects the cash flows to be $3 million a year, but itrecognizes that the cash flows could actually be much higher orlower, depending on whether the Korean government imposes a largehotel tax. One year from now, Kim will know whether the tax will beimposed. There is a 50% chance that the tax will be imposed, inwhich case the yearly cash flows will be only $2.2 million. At thesame time, there is a 50% chance that the tax will not be imposed,in which case the yearly cash flows will be $3.8 million. Kim isdeciding whether to proceed with the hotel today or to wait a yearto find out whether the tax will be imposed. If Kim waits a year,the initial investment will remain at $20 million. Assume that allcash flows are discounted at 13%. Use the Black-Scholes model toestimate the value of the option. Assume that the variance of theproject's rate of return is 0.0654 and that the risk-free rate is8%. Enter your answers in millions. For example, an answer of$10,550,000 should be entered as 10.55. Do not round intermediatecalculations. Round your answer to three decimal places.
Use computer software packages, such as Minitab or Excel, tosolve this problem.
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